Volatility, Intermediaries and Exchange Rates

56 Pages Posted: 20 Nov 2016 Last revised: 22 Dec 2019

See all articles by Xiang Fang

Xiang Fang

The University of Hong Kong

Yang Liu

The University of Hong Kong - Faculty of Business and Economics

Date Written: December 20, 2019

Abstract

We study exchange rate determination through financial intermediaries. We propose a model in which the participants in the FX market are intermediaries subject to value-at-risk constraints. Higher volatility translates into tighter leverage constraints. Therefore, intermediaries require higher returns to hold foreign assets and the foreign currency is expected to appreciate. Estimated by the simulated method of moments, our model quantitatively resolves the Backus-Smith puzzle, the forward premium puzzle, and the exchange rate volatility puzzle and explains deviations from covered interest rate parity. The model generates new implications for exchange rates and capital flows consistent with the data.

Keywords: Volatility, Financial Intermediaries, Exchange Rates, Currency Risk, Value-at-Risk

JEL Classification: G15, G20, F31

Suggested Citation

Fang, Xiang and Liu, Yang, Volatility, Intermediaries and Exchange Rates (December 20, 2019). Available at SSRN: https://ssrn.com/abstract=2872904 or http://dx.doi.org/10.2139/ssrn.2872904

Xiang Fang

The University of Hong Kong ( email )

Pokfulam Road
Hong Kong, Pokfulam HK
China

Yang Liu (Contact Author)

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

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